CHAPTER 14 Non-Current Liabilities LEARNING OBJECTIVES After studying this chapter, you should be able to: 4 Describe the nature of bonds and indicate the accounting for bond issuances. 2 Explain the accounting for long-term notes payable. 3 Explain the accounting for the extinguishment of non-current liabilities. 4 Indicate how to present and analyze non-current liabilities. PREVIEW OF CHAPTER 14 As our opening story indicates, companies may rely on different forms of long- term borrowing, depending on market conditions and the features of various non- current liabilities. In this chapter, we explain the accounting issues related to non- current liabilities. The content and organization of the chapter are as follows. This chapter also includes numerous conceptual discussions that are integral to the topics presented here. PCMESrErn eect Bonds Payable ‘Long-Term Notes Extinguishment of Presentation and + Typesot bond Payable Non-Current Liabitities | | analysis + Hesuingbonde + Notes issued afoce + Extingnstment with + Fair valve option + Valuationand accounting "36 cash beforematurity + offtaance-sheet {orbonde payable + Notesnotissued atface | | Extingushment by financing + Mlecvoderest volve eichangng asses oF + Presentation non neta + Special notes payable Secaines ‘urret lbities. stations. + extinguishment with + Analysis of nen-curent + Mortgagenctespayabie | | modification of Tapities Going Long The clock is ticking. Every second, it seems, the world takes on more debt. The following world debt clock (accessed in April 2017 at www.nationaldebtclocks.org) indicates the global figure for almost all government debts in dollar terms.‘Current Global Public Debt $69,784,610,512,606 This rising total is important for two reasons. First, when government debt rises faster than economic output (as it has been doing in recent years), this implies more state interference in the economy and higher taxes in the future. Second, debt must be rolled over at regular intervals. This creates a recurring popularity test for individual governments, much like reality-TV contestants facing a public phone vote every week. Fail that vote, as various euro-zone governments have done, and the country (and its neighbors) can be plunged into crisis. In addition to government debt, low interest rates and rising inflows into fixed-income funds have triggered record bond issuances as banks cut back lending. In addition, for some high-rated companies, it can be riskier to borrow from a bank than the bond markets. The reason: High-rated companies tend to rely on short-term commercial paper, backed up by undrawn loans, to fund working capital but are left stranded when these markets freeze up. Some are now financing themselves with longer-term bonds instead. In fact, long-term bonds are being issued at a record pace, with issuers looking to increase long-term borrowings, lock in low interest rates, and take advantage of investor demand. The following chart shows the substantial increase in bond issues as interest rates have fallen Companies, like Phillip Morris (USA), Sinopec (CHN), and Apple (USA), have all sold long-term bonds recently. Increases in the issuance of these bonds suggest confidence in the economy as investors appear comfortable holding such long-term investments. In addition, companies have a strong appetite for issuing these bonds because they provide a substantial cash infusion at a relatively low interest rate. Hopefully, it will work out for both the investor and the company in the long run Long-Term Bond Seles se * 085 96 200 06 06 08 10.12 1 16 (in eitions) ‘Sources: A. Sakoui and N. Bullock, "Companies Choose Bonds for Cheap Funds,” Financial Times (October 12, 2008): http:/www.economist.com/content/global_debt_clock, V. Monga, “Companies Feast on Cheap Money Market for 30-Year Bonds, Priced at Stark Lows, Brings Out GE, UPS and Other Once-Shy Issuers," Wall Street Journal (October 8, 2012); and Josh Noble, “Sinopec Raises €550m from Euro Bond Sale,” Financial Times (October 10, 2013)Review and Practice Go to the REVIEW AND PRACTICE section at the end of the chapter for a targeted summary review and practice problem with solution. Multiple-choice questions with annotated solutions as well as additional exercises and practice problem with solutions are also available online Bonds Payable LEARNING OBJECTIVE 1 Describe the nature of bonds and indicate the accounting for bond issuances. Non-current liabilities (sometimes referred to as long-term debt) consist of an expected outfiow of resources arising from present obligations that are not payable within a year or the operating cycle of the company, whichever is longer. Bonds payable, long-term notes payable, mortgages payable, pension liabilities, and lease liabilities are examples of non-current liabilities. ‘A company usually requires approval by the board of directors and the shareholders before bonds or notes can be issued. The same holds true for other types of long-term debt arrangements. Generally, long-term debt has various covenants or restrictions that protect both lenders and borrowers. The indenture or agreement often includes the amounts authorized to be issued, interest rate, due date(s), call provisions, property pledged as security, sinking fund requirements, working capital and dividend restrictions, and limitations concerning the assumption of additional debt. Companies should describe these features in the body of the financial statements or the notes if important for a complete understanding of the financial position and the results of operations Although it would seem that these covenants provide adequate protection to the long- term debtholder, many bondholders suffer considerable losses when companies add more debt to the capital structure. Consider what can happen to bondholders in leveraged buyouts (LBOs), which are usually led by management. In an LBO of RJR Nabisco (USA), for example, solidly rated 9% percent bonds plunged 20 percent in value when management announced the leveraged buyout. Such a loss in value occurs because the additional debt added to the capital structure increases the likelihood of default, Although covenants protect bondholders, they can still suffer losses when debt levels get too high Types of Bonds We define some of the more common types of bonds found in practice as followsTypes of Bonds Secured and Unsecured Bonds, Secured bonds are backed by a pledge of some sort of collateral. Mortgage bonds are secured by a claim on real estate. Collateral trust bonds are secured by shares and bonds of other companies Bonds not backed by collateral are unsecured. A debenture bond is unsecured, A “junk bond’ is unsecured and also very risky, and therefore pays a high interest rate. Companies often use these bonds to finance leveraged buyouts. Term, Serial Bonds, and Callable Bonds. Bond issues that mature on a single date are called term bonds; issues that mature in installments are called serial bonds, Serially maturing bonds are frequently used by school or sanitary districts, municipalities, or other local taxing bodies that receive money through a special levy. Callable bonds give the issuer the right to call and retire the bonds prior to maturity. Convertible, Commodity-Backed, and Deep-Discount Bonds. If bonds are convertible into other securities of the company for a specified time after issuance, they are convertible bonds. Two types of bonds have been developed in an attempt to attract capital in a tight money market—commodity-backed bonds and deep-discount bonds. Commodity-backed bonds (also called asset-linked bonds) are redeemable in measures of a commodity, such as barrels of oil, tons of coal, or ounces of rare metal, To illustrate, Sunshine Mining (USA), a silver-mining company, sold bonds that are redeemable with either $1,000 in cash or 50 ounces of silver, whichever is greater at maturity, and that have a stated interest rate of 8% percent. The accounting problem is one of projecting the maturity value, especially since silver has fluctuated between $4 and $40 an ounce since issuance. Deep-discount bonds, also referred to as zero-interest debenture bonds, are sold at a discount that provides the buyer's total interest payoff at maturity. Registered and Bearer (Coupon) Bonds, Bonds issued in the name of the owner are registered bonds and require surrender of the certificate and issuance of a new certificate to complete a sale. A bearer or coupon bond, however, is not recorded in the name of the owner and may be transferred from one owner to another by mere delivery. Income and Revenue Bonds. Income bonds pay no interest unless the issuing company is profitable, Revenue bonds, so called because the interest, on them is paid from specified revenue sources, are most frequently issued by airports, school districts, counties, toll-road authorities, and governmental bodies. Issuing Bonds A bond arises from a contract known as a bond indenture, A bond represents a promise to pay (1) a sum of money at a designated maturity date, plus (2) periodicinterest at a specified rate on the maturity amount (face value). Individual bonds are evidenced by a paper certificate and typically have a €1,000 face value. Companies usually make bond interest payments semiannually although the interest rate is generally expressed as an annual rate. As discussed in the opening story, the main purpose of bonds is to borrow for the long term when the amount of capital needed is too large for one lender to supply. By issuing bonds in €100, €1,000, or €10,000 denominations, a company can divide a large amount of long-term indebtedness into many small investing units, thus enabling more than one lender to participate in the loan. A company may sell an entire bond issue to an investment bank, which acts as a selling agent in the process of marketing the bonds. In such arrangements, investment banks may either underwrite the entire issue by guaranteeing a certain sum to the company, thus taking the risk of selling the bonds for whatever price they can get (firm underwriting). Or, they may sell the bond issue for a commission on the proceeds of the sale (best-efforts underwriting). Alternatively, the issuing company may sell the bonds directly to a large institution, financial or otherwise, without the aid of an underwriter (private placement).What Do the Numbers Mean? All About Bonds How do investors monitor their bond investments? One way is to review the bond listings found in the newspaper or online. Company bond listings show the coupon (interest) rate, maturity date, and last price. However, because company bonds are more actively traded by large institutional investors, the listings also indicate the current yield. Company bond listings would look as follows Issuer Coupon Maturity Price Yield Rating Vodafone Group 5.00 2018/06/04 106.66 4.05 AA Telecom Italia S.p.A. 5.25 2022/10/02 100.00 5.25 BB* The companies issuing the bonds are listed in the first column, in this case, two telecommunications companies, Vodafone Group (GBR) and Telecom Italia S.p.A (ITA). In the second column is the interest rate paid by the bond as a percentage of its par value, followed by its maturity date. The Vodafone bonds, for example, pay 5 percent and mature on June 4, 2018. The Telecom Italia bonds pay 5.25 percent, a bit higher. The Vodafone bonds have a current yield of 4.05 percent, based on the price of 108.66 per £1,000. In contrast, the Telecom Italia bonds at 100.00 yield 5.25 percent. The final column gives the bond rating Vodafone, with a rating of AA, is viewed as more creditworthy than Telecom Italia, which explains why Vodafone's bonds sell at a higher price and lower yield, Also, as indicated in the chapter, interest rates and the bond's term to maturity have a real effect on bond prices. For example, an increase in interest rates will lead to a decline in bond values. Similarly, a decrease in interest rates will lead to a rise in bond values. The following data, based on three different bond funds, demonstrate these relationships between interest rate changes and bond values. Bond Price Changes in 1% Interest Rate 1% Interest Rate Response to Interest Increase Decrease Rate Changes Short-term fund (2-5 years) -2.5% 42.5% Intermediate-term fund (5 -5% +5% years) Long-term fund (10 years) -10% +10% Source: The Vanguard Group. Another factor that affects bond prices is the call feature, which decreases the value of the bond. Investors must be rewarded for the risk that the issuer will call the bond if interest rates decline, which would force the investor to reinvest at lower rates.Valuation and Accounting for Bonds Payable The issuance and marketing of bonds to the public does not happen overnight. It usually takes weeks or even months. First, the issuing company must arrange for underwriters that will help market and sell the bonds. Then, it must obtain regulatory approval of the bond issue, undergo audits, and issue a prospectus (a document that describes the features of the bond and related financial information). Finally, the company must generally have the bond certificates printed. Frequently, the issuing company establishes the terms of a bond indenture well in advance of the sale of the bonds. Between the time the company sets these terms and the time it issues the bonds, the market conditions and the financial position of the issuing company may change significantly. Such changes affect marketability of the bonds and thus their selling price. The selling price of a bond issue is set by the supply and demand of buyers and sellers, relative risk, market conditions, and the state of the economy. The investment community values a bond at the present value of its expected future cash flows, which consist of (1) interest and (2) principal. The rate used to compute the present value of these cash flows is the interest rate that provides an acceptable return on an investment commensurate with the issuer's risk characteristics. The interest rate written in the terms of the bond indenture (and often printed on the bond certificate) is known as the stated, coupon, or nominal rate, The issuer of the bonds sets this rate. The stated rate is expressed as a percentage of the face value of the bonds (also called the par value, principal amount, or maturity value) Bonds Issued at Par If the rate employed by the investment community (buyers) is the same as the stated rate, the bond sells at par, That is, the par value equals the present value of the bonds computed by the buyers (and the current purchase price). To illustrate the computation of the present value of a bond issue, assume that Santos SA issues R$100,000 in bonds dated January 1, 2019, due in five years with 9 percent interest payable annually on January 1. At the time of issue, the market rate for such bonds is 9 percent. The time diagram in Illustration 14.1 depicts both the interest and the principal cash flows. pon 59,000 R§9,000 Rs9.000____8$9,000 8,000 Interest = (MSNELE] Time Diagram for Bonds Issued at Par The actual principal and interest cash flows are discounted at a 9 percent rate for five periods, as shown in Illustration 14.2Present Value Computation of Bond Selling at Par Present value of the principal: $100,000 x .64993 (Table 14.2) R$ 64,993 Present value of the interest payments: $9,000 x 3.88965 (Table 14.4) 35,007 Present value (selling price) of the bonds R$100,000 By paying R$100,000 (the par value) at the date of issue, investors realize an effective rate or yield of 9 percent over the five-year term of the bonds. Santos makes the following entries in the first year of the bonds January 1, 2019 (Issue Bonds) Cash 100,000 Bonds Payable 100,000 December 31, 2019 (Accrued Interest Expense) Interest Expense (R$100,000 x .09)| 9,000 Interest Payable 9,000 January 1, 2020 Interest Payable 9,000 Cash 9,000 Bonds Issued at Discount or Premium If the rate employed by the investment community (buyers) differs from the stated rate, the present value of the bonds computed by the buyers (and the current purchase price) will differ from the face value of the bonds. The difference between the face value and the present value of the bonds determines the actual price that buyers pay for the bonds. This difference is either a discount or premium + Ifthe bonds sell for less than face value, they sell at a discount. + Ifthe bonds sell for more than face value, they sell at a premium. The rate of interest actually eared by the bondholders is called the effective yield or market rate. If bonds sell at a discount, the effective yield exceeds the stated rate Conversely, if bonds sell at a premium, the effective yield is lower than the stated rate. Several variables affect the bond's price while it is outstanding, most notably the market rate of interest. There is an inverse relationship between the market interest rate and the price of the bond. To illustrate, assume now that Santos issues R$100,000 in bonds, due in five years with 9 percent interest payable annually at year-end, At the time of issue, the market rate for such bonds is 11 percent. The time diagram in Illustration 14.3 depicts both the interest and the principal cash flows.iu pvon 59,000 ___R$9.000 _—_—RS9,000___—_RS9,000___RS8.00 Interest | [MUSTINELE] Time Diagram for Bonds Issued at a Discount The actual principal and interest cash flows are discounted at an 11 percent rate for five periods, as shown in Illustration 14.4, Present Value Computation of Bond Selling at a Discount Present value of the principal: R$100,000 * .59345 (Table 14.2) R$59,345.00 Present value of the interest payments: R$9,000 x 3.69590 (Table 14.4) 33,263.10 Present value (selling price) of the bonds R$92,608.10 By paying R$92,608 at the date of issue, investors realize an effective rate or yield of 11 percent over the five-year term of the bonds. These bonds would sell at a discount of $7,392 (R$100,000 ~ R$92,608). The price at which the bonds sell is typically stated as a percentage of the face or par value of the bonds. For example, the Santos bonds sold for 92.6 (92.6% of par). If Santos had received R$ 102,000, then the bonds sold for 102 (102% of par) When bonds sell at less than face value, it means that investors demand a rate of interest higher than the stated rate. Usually, this occurs because the investors can eam a higher rate on alternative investments of equal risk. They cannot change the stated rate, so they refuse to pay face value for the bonds. Thus, by changing the amount invested, they alter the effective rate of return. The investors receive interest at the stated rate computed on the face value, but they actually eam at an effective rate that exceeds the stated rate because they paid less than face value for the bonds. (Later in the chapter, in Illustrations 14.8 and 14.9 present a bond that sells at a premium.)What Do the Numbers Mean? How About a 100-Year Bond? Yes, some companies issue bonds with maturities that exceed a person's lifetime. For example, Electricité de France S.A. (FRA) in early 2014 sold 10-year bonds in Europe. In addition, countries such as Ireland and Mexico have recently sold 10-year government bonds. Why do these companies and countries issue 100-year bonds? A number of investors, such as pension funds and insurance companies, have non-current liabilities. They need long-duration assets to reduce an asset-liability mismatch. While investing in a 100-year bond carries interest-rate risk, long-term debt has an offsetting effect against long-duration assets. Thus, this group of investors has a strong demand for these bonds. Other multibillion-dollar companies, such as Walt Disney Company (USA) and The Coca-Cola Company (USA), have issued 100-year bonds in the past. Many of these bonds and debentures contain an option that lets the debt issuer partially or fully repay the debt long before the scheduled maturity. For example, the 100- year bond that Disney issued in 1993 is supposed to mature in 2093, but the company can start repaying the bonds any time after 30 years (2023) You may be surprised to learn that 1,000-year bonds also exist. A few issuers, such as the Canadian Pacific Corporation (CAN), have issued such bonds in the past. And, there have also been instances of bonds issued with no maturity date at all, meaning that the debt issuers continue fulfilling the coupon payments. forever. These types of financial instruments are commonly referred to as perpetuities. Sources: Albert Phung, ‘Why Do Companies Issue 100-Year Bonds?" Investopedia (February 2009); and K. Linsell, “EDF's Borrowing Exceeds $12 Billion This Week with 100-Year Bond,” Bloomberg (January 17, 2014); and Dara Doyle, “Ireland Sells First 10-year Bond, Staying On Comeback Trail,” Bloomberg (March 16, 2016) Effective-Interest Method As discussed earlier, by paying more or less at issuance, investors eam a rate different than the coupon rate on the bond, Recall that the issuing company pays the contractual interest rate over the term of the bonds but also must pay the face value at maturity. If the bond is issued at a discount, the amount paid at maturity is more than the issue amount. If issued at a premium, the company pays less at maturity relative to the issue price. The company records this adjustment to the cost as bond interest expense over the life of the bonds through a process called amortization, Amortization of a discount increases bond interest expense. Amortization of a premium decreases bond interest expense. The required procedure for amortization of a discount or premium is the effective- interest method (also called present value amortization). Under the effective-interest method, companies: [1] (See the Authoritative Literature References section near the end of the chapter.) 1. Compute bond interest expense first by multiplying the carrying value (book value) of the bonds at the beginning of the period by the effective-interest rate? 2. Determine the bond discount or premium amortization next by comparing the bond interest expense with the interest (cash) to be paid. Illustration 14.5 depicts graphically the computation of the amortization. Bond Interest Expense ‘Bond interest Paid ct m ‘Amortization Bonds : ‘amount Bond Discount and Premium Amortization Computation The effective-interest method produces a periodic interest expense equal to a constant percentage of the carrying value of the bonds.* Bonds Issued at a Discount To illustrate amortization of a discount under the effective-interest method, assume Evermaster AG issued €100,000 of 8 percent term bonds on January 1, 2015, due on January 1, 2020, with interest payable each July 1 and January 1. Because the investors required an effective-interest rate of 10 percent, they paid €92,278 for the €100,000 of bonds, creating a €7,722 discount. Evermaster computes the €7,722 discount as shown in Illustration 14.6.4 Computation of Discount on Bonds Payable Maturity value of bonds payable €100,000 Present value of €100,000 due in 5 years at 10%, interest €61,391 payable semiannually (Table 14.2); FV(PVF19 5); (€100,000 x 61391) Present value of €4,000 interest payable semiannually for 5 years _30,887 at 10% annually (Table 14.4); R(PVF-OAvo,5x); (€4,000 7.72173) Proceeds from sale of bonds 92,278) Discount on bonds payable € 7,722 The five-year amortization schedule appears in Illustration 14.7.Bond Discount Amortization Schedule SCHEDULE OF BOND DISCOUNT AMORTIZATION EFFecTIVE-INTEREST METHOD—SEMIANNUAL INTEREST PAYMENTS. 5-YEAR, 8% BoNDs SOLD To YIELD 10% Date Cash Paid Interest Expense Discount Amortized Carrying Amount of Bonds 19 € 92,278 TANG € 4,000a—€ 4,614b € 614c 92,8924 11/20, 4,000 4,645 645 93,537 7/1120 4,000 4677 677 94,214 1/1/21, 4,000 4714 71 94,925 7/1121 4,000 4,746 746 95,671 111122, 4,000 4,783 783 96,454 7/1122, 4,000 4,823 823 97,277 1/1123, 4,000 4,864 864 98,141 7/1123, 4,000 4,907 907 99,048 1/1/24 _ 4,000 4,952 952 100,000 £40,000 €47,722 * €4,000 = €100,000 x .08 x 6/12 © €4,614 = €92,278 x 10 x 6/12 © €614 = €4,614 - €4,000 % €92,892 = €92,278 + €614 Evermaster records the issuance of its bonds at a discount on January 1, 2019, as follows Cash 92,278 Bonds Payable 92,278 It records the first interest payment on July 1, 2019, and amortization of the discount as follows. Interest Expense 4,614 Bonds Payable 614 Cash 4,000 Evermaster records the interest expense accrued at December 31, 2019 (year-end), and amortization of the discount as follows.Interest Expense |4,645 Interest Payable 4,000 Bonds Payable 645 feotvae I Stone touts Annet 00.9%0 Underlying Concepts Because bond issue costs do not meet the definition of an asset, some argue they should be expensed at issuance Bonds Issued at a Premium Now assume that for the bond issue described above, investors are willing to accept an effective-interest rate of 6 percent. In that case, they would pay €108,530 or a premium of €8,530, computed as shown in Illustration 14.8 Computation of Premium on Bonds Payable Maturity value of bonds payable €100,000 Present value of €100,000 due in 5 years at 6%, interest payable €74,409 semiannually (Table 14.2); FV(PVF 9.3); (€100,000 x .74409) Present value of €4,000 interest payable semiannually for 5 34,124 years at 6% annually (Table 14.4); R(PVF-OA1o.3x); (€4,000 x 8.53020) Proceeds from sale of bonds (108,530) Premium on bonds payable €_8,530 The five-year amortization schedule appears in Illustration 14.9.[MSTNEEE] Bond Premium Amortization Schedule SCHEDULE OF BOND PREMIUM AMORTIZATION EFFecTIVE-INTEREST METHOD—SEMIANNUAL INTEREST PAYMENTS. 5-YEAR, 8% Bons SoLp To YieLo 6% Date Cash Paid Interest Expense Premium Amortized Carrying Amount of Bonds, 1g €108,530 TMAY € 4,000a—€ -3,256b € 7440 107,786d 1/1/20 4,000 3,234 766 107,020 7/1/20 4,000 3,211 789 106,231 11121 4,000 3,187 813 105,418 7/1121 4,000 3,162 838 104,580 11122, 4,000 3,137 863 103,717 7/1122 4,000 3,112 888 102,829 11123 4,000 3,085 915 101,914 7/1/23 4,000 3,057 943 100,971 1/1124 _ 4,000 3,029 _971 100,000 €40,000 €31,470 €8,530 * €4,000 = €100,000 x .08 x 6/12 €3,256 = €108,530 * .06 x 6/12 © €744 = €4,000 ~ €3,256 $ €107,786 = €108,530 - €744 Evermaster records the issuance of its bonds at a premium on January 1, 2019, as follows. Cash 108,530 Bonds Payable 108,530 Evermaster records the first interest payment on July 1, 2019, and amortization of the premium as follows. Interest Expense | 3,256 Bonds Payable | 744 Cash 4,000 Evermaster should amortize the discount or premium as an adjustment to interest expense over the life of the bond in such a way as to result in a constant rate of interest when applied to the carrying amount of debt outstanding at the beginning of any given period.>a ledtorsobtiontor Freset vue ions Inputs Answer 00.9%0 EBEBE g g Accruing Interest In our previous examples, the interest payment dates and the date the financial statements were issued were essentially the same. For example, when Evermaster sold bonds at a premium, the two interest payment dates coincided with the financial reporting dates. However, what happens if Evermaster prepares financial statements at the end of February 20197 In this case, as Illustration 14.10 shows, the company prorates the premium by the appropriate number of months to arrive at the proper interest expense. Computation of Interest Expense Interest accrual (€4,000 x 2/6) €1,333.33 Premium amortized (€744 x 2/6) _ (248.00) Interest expense (Jan.Feb.) _€1,085.33, Evermaster records this accrual as follows. Interest Expense 1,085.33 Bonds Payable 248.00 Interest Payable 1,333.33 If the company prepares financial statements six months later, it follows the same procedure. That is, the premium amortized would be as shown in Illustration 14.11 Computation of Premium Amortization Premium amortized (March—June) (€744 x 4/6) €496.00 Premium amortized (July-August) (€766 2/6) 255.33 Premium amortized (March—August 2019) €751.33, Bonds Issued Between Interest Dates‘Companies usually make bond interest payments semiannually, on dates specified in the bond indenture. When companies issue bonds on other than the interest payment dates, bond investors will pay the issuer the interest accrued from the last interest payment date to the date of issue. The bond investors, in effect, pay the bond issuer in advance for that portion of the full six-months' interest payment to which they are not entitled because they have not held the bonds for that period. Then, on the next semiannual interest payment date, the bond investors will receive the full six-months' interest payment. Bonds Issued at Par. To illustrate, assume that instead of issuing its bonds on January 1, 2019, Evermaster issued its five-year bonds, dated January 1, 2019, on May 1, 2019, at par (€100,000). Evermaster records the issuance of the bonds between interest dates as follows. May 1, 2019 Cash 100,000 Bonds Payable 100,000 (To record issuance of bonds at par) Cash 2,667 Interest Expense (€100,000 x .08 x 4/12) 2,667 (To record accrued interest; Interest Payable might be credited instead) Because Evermaster issues the bonds between interest dates, it records the bond issuance at par (€100,000) plus accrued interest (€2,667). That is, the total amount paid by the bond investor includes four months of accrued interest. On July 1, 2019, two months after the date of purchase, Evermaster pays the investors six months’ interest, by making the following entry. July 1, 2019 Interest Expense (€100,000 x .08 x 6/2) 4,000 Cash 4,000 (To record first interest payment) The Interest Expense account now contains a debit balance of €1,333 (€4,000 - €2,667), which represents the proper amount of interest expense—two months at 8 percent on €100,000.Interest Expense S/N19 2,667" 7HMM9 4,000° Balance 1,333 * Accrued interest received ° Cash paid, Bonds Issued at Discount or Premium. The illustration above was simplified by having the January 1, 2019, bonds issued on May 1, 2019, at par. However, if the bonds are issued at a discount or premium between interest dates, Evermaster must not only account for the partial cash interest payment but also the amount of effective amortization for the partial period, To illustrate, assume that the Evermaster 8-percent bonds were issued on May 1, 2019, to yield 6 percent. Thus, the bonds are issued at a premium; in this case, the price is €108,039.2 Evermaster records the issuance of the bonds between interest dates as follows. May 1, 2019 Cash 108,039 Bonds Payable 108,039 (To record the present value of the cash flows) Cash 2,667 Interest Expense (€100,000 x .08 x 4/12) 2,667 (To record accrued interest; Interest Payable might be credited instead) In this case, Evermaster receives a total of €110,706 at issuance, comprised of the bond price of €108,039 plus the accrued interest of €2,667. Following the effective- interest procedures, Evermaster then determines interest expense from the date of sale (May 1, 2019), not from the date of the bonds (January 1, 2019) Illustration 14.12 provides the computation, using the effective-interest rate of 6 percent. Partial Period Interest Amortization Interest Expense Carrying value of bonds €108,039 Effective-interest rate (6% x 2/12) 1% Interest expense for two months €_1,080 The bond interest expense therefore for the two months (May and June) is €1,080.The premium amortization of the bonds is also for only two months. It is computed by taking the difference between the net cash paid related to bond interest and the effective-interest expense of €1,080. Illustration 14.13 shows the computation of the partial amortization, using the effective-interest rate of 6 percent. (MESITNELEE Partial Period Interest Amortization Cash interest paid on July 1, 2019 (€100,000 x 8% x 6/12) | €4,000 Less: Cash interest received on May 2, 2019 2,667 Net cash paid €1,333 Bond interest expense (at the effective rate) for two months _(1,080} Premium amortization € 253 As indicated, both the bond interest expense and amortization reflect the shorter two- month period between the issue date and the first interest payment. Evermaster therefore makes the following entries on July 1, 2019, to record the interest payment and the premium amortization. July 1, 2019 Interest Expense 4,000 Cash 4,000 (To record first interest payment) Bonds Payable 253 Interest Expense 253 (To record two months’ premium amortization) The Interest Expense account now contains a debit balance of €1,080 (€4,000 - €2,667 - €253), which represents the proper amount of interest expense—two months at an effective annual interest rate of 6 percent on €108,039. Interest Expense 5/1/19 2,667" TANG 4,000” 7/1/19 253° Balance 1,080 * Accrued interest received. ° Cash paid. © 2 months’ amortization. Long-Term Notes PayableLEARNING OBJECTIVE 2 Explain the accounting for long-term notes payable. The difference between current notes payable and long-term notes payable is the maturity date, As discussed in Chapter 13, short-term notes payable are those that companies expect to pay within a year or the operating cycle—whichever is longer. Long-term notes are similar in substance to bonds in that both have fixed maturity dates and carry either a stated or implicit interest rate. However, notes do not trade as readily as bonds in the organized public securities markets. Small companies issue notes as their long-term instruments. Larger companies issue both long-term notes and bonds Accounting for notes and bonds is quite similar. Like a bond, a note is valued at the present value of its future interest and principal cash flows. The company amortizes any discount or premium over the life of the note, just as it would the discount or premium on a bond. Companies compute the present value of an interest- bearing note, record its issuance, and amortize any discount or premium and accrual of interest in the same way that they do for bonds As you might expect, accounting for long-term notes payable parallels accounting for long-term notes receivable, as was presented in Chapter 7. Notes Issued at Face Value In Chapter 7, we discussed the recognition of a €10,000, three-year note Scandinavian Imports issued at face value to Bigelow ASA. In this transaction, the stated rate and the effective rate were both 10 percent, The time diagram and present value computation in Chapter 7 (see Illustration 7.12) for Bigelow would be the same for the issuer of the note, Scandinavian Imports, in recognizing a note payable. Because the present value of the note and its face value are the same, €10,000, Scandinavian would recognize no premium or discount. It records the issuance of the note as follows Cash 10,000 Notes Payable 10,000 Scandinavian Imports would recognize the interest incurred each year as follows. Interest Expense (€10,000 x .10) 1,000 Cash 1,000 Notes Not Issued at Face Value Zero-Interest-Bearing Notes If a company issues a zero-interest-bearing (non-interest-bearing) note? solely for cash, it measures the note's present value by the cash received, The implicit interest rate is the rate that equates the cash received with the amounts to be paid in thefuture. The issuing company records the difference between the face amount and the present value (cash received) as a discount and amortizes that amount to interest expense over the life of the note. An example of such a transaction is Beneficial Corporation's (USA) offering of $150 million of zero-coupon notes (deep-discount bonds) having an eight-year life. With a face value of $1,000 each, these notes sold for $327—a deep discount of $673 each. The present value of each note is the cash proceeds of $327. We can calculate the interest rate by determining the rate that equates the amount the investor currently pays with the amount to be received in the future. Thus, Beneficial amortizes the discount over the eight-year life of the notes using an effective-interest rate of 15 percent = To illustrate the entries and the amortization schedule, assume that Turtle Cove Company issued the three-year, $10,000, zero-interest-bearing note to Jeremiah Company illustrated in Chapter 7 (notes receivable). The implicit rate that equated the total cash to be paid ($10,000 at maturity) to the present value of the future cash flows (87,721.80 cash proceeds at date of issuance) was 9 percent. (The present value of $1 for three periods at 9 percent is $0.77218.) Illustration 14.14 shows the time diagram for the single cash flow. wv $10,000 Principal Peon 0 $0 Sointeest [MUETUENEZEL] Time Diagram for Zero-Interest Note Turtle Cove records issuance of the note as follows. Cash 7,721.80 Notes Payable 7,721.80 Turtle Cove amortizes the discount and recognizes interest expense annually using the effective-interest method. Illustration 14.15 shows the three-year discount amortization and interest expense schedule, (This schedule is similar to the note receivable schedule of Jeremiah Company in Illustration 14.14.)Schedule of Note Discount Amortization SCHEDULE OF NOTE DISCOUNT AMORTIZATION Errective-INTEREST METHOD, 0% Note Discounrep at 9% Interest Discount Expense Amortized Date of issue End of year 1 $O- $ 694.967 $ 694.96" End of year 2 —0- 757.51 757.51 End of year 3 0- _ 825.734 825.73 S$-0- $2,278.20 __ $2,278.20 * $7,721.80 x .09 = $694.96 ® $694.96 - 0 = $694.96 © $7,721.80 + $694.96 = $8,416.76 *'5¢ adjustment to compensate for rounding. Carrying Amount of Not $ 7,721.80 8,416.76" 9,174.27 10,000.00 Turtle Cove records interest expense at the end of the first year using the effective- interest method as follows. Interest Expense ($7,721.80 x 9%) 694.96 Notes Payable 694.96 The total amount of the discount, $2,278.20 in this case, represents the expense that Turtle Cove Company will incur on the note over the three years. ledotorsoitiontor Etec terse, eputs Answer wi: gw a-Interest-Bearing Notes The zero-interest-bearing note above is an example of the extreme difference between the stated rate and the effective rate. In many cases, the difference between these rates is not so great. Consider the example from Chapter 7 where Marie Co. issued for cash a €10,000, three-year note bearing interest at 10 percent to Morgan Group. The market rate of interest for a note of similar risk is 12 percent, Illustration 14.15 shows the time diagram depicting the cash flows and the computation of the present value of this note. In this case, because the effective rate of interest (12%) is greater than the stated rate (10%), the present value of the note is less than the face value. That is, the note is exchanged at a discount. Marie Co. records the issuance of the note as follows. Cash 9,520 Notes Payable 9,520 Marie Co. then amortizes the discount and recognizes interest expense annually using the effective-interest method. Illustration 14.16 shows the three-year discount amortization and interest expense schedule. [MESTINELED] Schedule of Note Discount Amortization SCHEDULE OF NOTE DISCOUNT AMORTIZATION Errectiv 10% Note Discounten aT 12% INTEREST METHOD Interest Discount Carrying Expense Amortized | Amount of ‘Note Date of issue € 9,520 End of year 1 €1,000° — €1,142° €142° 9,662" End of year 2 1,000 1,159 159 9,821 End of year 3 4000 _4,179 179 10,000 €3,000 __ €3.480 €480 * €10,000 x 10% = €1,000 ° €9,520 x 12% = €1,142 © €1,142 - €1,000 = €142 €9,520 + €142 = €9,662 Marie Co. records payment of the annual interest and amortization of the discount for the first year as follows (amounts per amortization schedule)Interest Expense 1,142 Notes Payable 142 Cash 1,000 When the present value exceeds the face value, Marie Co. exchanges the note at a premium. It does so by recording the premium as a credit to Notes Payable and amortizing it using the effective-interest method over the life of the note as annual reductions in the amount of interest expense recognized. Special Notes Payable Situations Notes Issued for Property, Goods, or Services ‘Sometimes, companies may receive property, goods, or services in exchange for a note payable. When exchanging the debt instrument for property, goods, or services in a bargained transaction entered into at arm's length, the stated interest rate is presumed to be fair unless: 1. No interest rate is stated, or 2. The stated interest rate is unreasonable, or 3. The stated face amount of the debt instrument is materially different from the current cash sales price for the same or similar items or from the current fair value of the debt instrument. In these circumstances, the company measures the present value of the debt instrument by the fair value of the property, goods, or services or by an amount that reasonably approximates the fair value of the note. [3] If there is no stated rate of interest, the amount of interest is the difference between the face amount of the note and the fair value of the property For example, assume that Scenic Development AS sells land having a cash sale price of €200,000 to Health Spa Services. In exchange for the land, Health Spa gives a five- year, €293,866, zero-interest-bearing note. The €200,000 cash sale price represents the present value of the €293,866 note discounted at 8 percent for five years. Should both parties record the transaction on the sale date at the face amount of the note, which is €293,866? No—if they did, Health Spa's Land account and Scenic’s sales would be overstated by €93,866 (the interest for five years at an effective rate of 8 percent). Similarly, interest revenue to Scenic and interest expense to Health Spa for the five-year period would be understated by €93,86. Because the difference between the cash sale price of €200,000 and the €293,866 face amount of the note represents interest at an effective rate of 8 percent, the companies’ transaction is recorded at the exchange date as shown in Illustration 14.17. Entries for Non-Cash Note Transaction Health Spa Services (Buyer) _ Scenic Development AS (Seller) Land 200,000 Notes Receivable 200,000 Notes Payable 200,000 Sales Revenue 200,000During the five-year life of the note, Health Spa amortizes annually a portion of the discount of €93,866 as a charge to interest expense. Scenic Development records interest revenue totaling €93,866 over the five-year period by also amortizing the discount. The effective-interest method is required, unless the results obtained from using another method are not materially different from those that result from the effective-interest method. Choice of Interest Rate In note transactions, the effective or market interest rate is either evident or determinable by other factors involved in the exchange, such as the fair value of what is given or received. But, if a company cannot determine the fair value of the property, goods, services, or other rights, and if the note has no ready market, the problem of determining the present value of the note is more difficult. To estimate the present value of a note under such circumstances, a company must approximate an applicable interest rate that may differ from the stated interest rate. This process of interest-rate approximation is called imputation, and the resulting interest rate is called an imputed interest rate. The prevailing rates for similar instruments of issuers with similar credit ratings affect the choice of a rate. Other factors such as restrictive covenants, collateral, payment schedule, and the existing prime interest rate also play a part. Companies determine the imputed interest rate when they issue a note; any subsequent changes in prevailing interest rates are ignored. To illustrate, assume that on December 31, 2019, Wunderlich ple issued a promissory note to Brown Interiors Company for architectural services. The note has a face value of £550,000, a due date of December 31, 2024, and bears a stated interest rate of 2 percent, payable at the end of each year. Wunderlich cannot readily determine the fair value of the architectural services, nor is the note readily marketable. On the basis of Wunderlich's credit rating, the absence of collateral, the prime interest rate at that date, and the prevailing interest on Wunderlich's other outstanding debt, the company imputes an 8 percent interest rate as appropriate in this circumstance. Illustration 14.18 shows the time diagram depicting both cash flows. ~ £559,000 Principal i=09 pv.on f11900___ 11000 "1,000 £11,000 £1,000 terest [MNETUENEEED Time Diagram for interest-Bearing Note Illustration 14.19 shows the calculation of the present value of the note and the imputed fair value of the architectural services.Computation of Imputed Fair Value and Note Discount Face value of the note £ 550,000 Present value of £550,000 due in 5 years at 8% interest £374,319 payable annually (Table 14.2); FV(PVFs.ex); (£550,000 x 68058) Present value of £11,000 interest payable annually for 5 years _ 43,920 at 8%; R(PVF-OAs.sx); (£11,000 x 3.99271) Present value of the note (418,239) Discount on notes payable £131,761 Wunderlich records issuance of the note in payment for the architectural services as follows. December 31, 2019 Buildings (or Construction in Process) 418,239 Notes Payable 418,239 The five-year amortization schedule is presented in Illustration 14.20.RATION 11 3] Schedule of Discount Amortization Using Imputed Interest Rate SCHEDULE OF NOTE COUNT, AMORTIZATION EFFecTIVE-INTEREST METHOD, 2% Note DiscouNTED AT IMpUTED) Date Cash Paid Interest Discount Carrying (2%) Expense Amortized Amount of (8%) Note 12131119 £418,239 12131120 £11,000" £ 33,459" £ 22,459° 440,698° 12/31/20 11,000 35,256 24,256 464,954 12/31/22 11,000 37,196 26,196 491,150 12/31/23 11,000 39,292 28,292 519,442 12131124 411,000 41,558" 30,558 550,000 £55,000 _ £186,761 _ £131,761 * £550,000 x 2% = £11,000 ° £418,239 x 8% = £33,459 © £33,459 - £11,000 = £22,459 £418,239 + £22,459 = £440,698 © £3 adjustment to compensate for rounding, Wunderlich records payment of the first year's interest and amortization of the discount as follows. December 31, 2020 Interest Expense 33,459 Notes Payable 22,459 Cash 11,000thei lee Senices = = soe ol): oa) a irc dno ung Mortgage Notes Payable A common form of long-term notes payable is a mortgage note payable. A mortgage note payable is a promissory note secured by a document called a mortgage that pledges title to property as security for the loan. Individuals, proprietorships, and partnerships use mortgage notes payable more frequently than do larger companies (which usually find that bond issues offer advantages in obtaining large loans) The borrower usually receives cash for the face amount of the mortgage note. In that case, the face amount of the note is the true liability, and no discount or premium is involved. When the lender assesses “points,” however, the total amount received by the borrower is less than the face amount of the note © Points raise the effective- interest rate above the rate specified in the note. A point is 1 percent of the face of the note. For example, assume that Harrick Co. borrows $1,000,000, signing a 20-year mortgage note with a stated interest rate of 10.75 percent as part of the financing for a new plant. If Associated Savings demands 4 points to close the financing, Harrick will receive 4 percent less than $1,000,000—or $960,000—but it will be obligated to repay the entire $1,000,000 at the rate of $10,150 per month. Because Harrick received only $960,000 and must repay $1,000,000, its effective-interest rate is increased to approximately 11.3 percent on the money actually borrowed. On the statement of financial position, Harrick should report the mortgage note payable as a liability using a title such as “Mortgage Notes Payable” or "Notes Payable—Secured,” with a brief disclosure of the property pledged in notes to the financial statements. Mortgages may be payable in full at maturity or in installments over the life of the loan If payable at maturity, Harrick classifies its mortgage payable as a non-current liability on the statement of financial position until such time as the approaching maturity date warrants showing it as a current liability. If it is payable in installments, Harrick shows the current installments due as current liabilities, with the remainder as a non-current liability.Lenders have partially replaced the traditional fixed-rate mortgage with alternative mortgage arrangements. Most lenders offer variable-rate mortgages (also called floating rate or adjustable-rate mortgages) featuring interest rates tied to changes in the fluctuating market rate. Generally, the variable-rate lenders adjust the interest rate at either one- or three-year intervals, pegging the adjustments to changes in the prime rate or the London Interbank Offering rate (LIBOR).. Extinguishment of Non-Current Liabilities LEARNING OBJECTIVE 3. Explain the accounting for extinguishment of non-current liabilities. How do companies record the payment of non-current liabilities—often referred to as extinguishment of debt? if a company holds the bonds (or any other form of debt security) to maturity, the answer is straightforward: The company does not compute any gains or losses. It will have fully amortized any premium or discount and any issue costs at the date the bonds mature. As a result, the carrying amount, the maturity (face) value, and the fair value of the bond are the same. Therefore, no gain or loss exists. In this section, we discuss extinguishment of debt under three common additional situations: 4. Extinguishment with cash before maturity, 2, Extinguishment by transferring assets or securities, and 3. Extinguishment with modification of terms. Extinguishment with Cash before Maturity In some cases, a company extinguishes debt before its maturity date“ The amount paid on extinguishment or redemption before maturity, including any call premium and expense of reacquisition, is called the reacquisition price. On any specified date, the carrying amount of the bonds is the amount payable at maturity, adjusted for unamortized premium or discount. Any excess of the net carrying amount over the reacquisition price is a gain from extinguishment. The excess of the reacquisition price over the carrying amount is a loss from extinguishment. At the time of , the unamortized premium or discount must be amortized up to the reacquisition date. To illustrate, we use the Evermaster bonds issued at a discount on January 1, 2019. These bonds are due in five years. The bonds have a par value of €100,000, a coupon rate of 8 percent paid semiannually, and were sold to yield 10 percent. The amortization schedule for the Evermaster bonds is presented in Illustration 14.21.Bond Premium Amortization Schedule, Bond Extinguishment SCHEDULE OF BOND DISCOUNT AMORTIZATION Errective-InTerest METHOD SEMIANNUAL INTEREST PAYMENTS EAR, 8% Bonps SOLD To Yiewo 10 Date Interest Discount Carrying Expense Amortized Amount of Bonds 119 € 92,278 TANG € 4,000? € 4614" € 614° 92,892° 111/20 4,000 4,645 645 93,537 7/1120 4,000 4,677 677 94,214 024 4000 4,711 71 94,925 724 4,000 4,746 746 95,671 111122 4,000 4,783 783 96,454 722 4,000 4,823 823 97,277 111123 4,000 4,864 864 98,141 71123 4,000 4,907 907 99,048 1124 4,000 _ 4.952 952 100,000 €40,000 _ €47,722 €7,722 # €4,000 = €100,000 x .08 x 6/12 ° €4,614 = €92,278 x 10 x 6/12 © €614 = €4,614 - €4,000 © €92,892 = €92,278 + €614 ‘Two years after the issue date on January 1, 2021, Evermaster calls the entire issue at 101 and cancels it! As indicated in the amortization schedule, the carrying value of the bonds on January 1, 2021, is €94,925. Illustration 14.22 how Evermaster computes the loss on redemption (extinguishment). Computation of Loss on Redemption of Bonds Reacquisition price (€100,000 x 1.01) €101,000 Carrying amount of bonds redeemed _(94,925) Loss on extinguishment €_ 6,075 Evermaster records the reacquisition and cancellation of the bonds as follows.Bonds Payable 94,925 Loss on Extinguishment of Debt 6,075 Cash 101,000 Note that itis offen advantageous for the issuer to acquire the entire outstanding bond issue and replace it with a new bond issue bearing a lower rate of interest. The replacement of an existing issuance with a new one is called refunding. Whether the early redemption or other extinguishment of outstanding bonds is a non-refunding or a refunding situation, a company should recognize the difference (gain or loss) between the reacquisition price and the carrying amount of the redeemed bonds in income of the period of redemption Extinguishment by Exchanging Assets or Securities, In addition to using cash, settling a debt obligation can involve either a transfer of non- cash assets (real estate, receivables, or other assets) or the issuance of the debtor's shares. In these situations, the creditor should account for the non-cash assets or equity interest received at their fair value The debtor must determine the excess of the carrying amount of the payable over the fair value of the assets or equity transferred (gain)*2 The debtor recognizes a gain equal to the amount of the excess. In addition, the debtor recognizes a gain or loss on disposition of assets to the extent that the fair value of those assets differs from their carrying amount (book value) Transfer of Assets Assume that Hamburg Bank loaned €20,000,000 to Bonn Mortgage Company. Bonn, in turn, invested these monies in residential apartment buildings. However, because of low occupancy rates, it cannot meet its loan obligations. Hamburg Bank agrees to accept from Bonn Mortgage real estate with a fair value of €16,000,000 in full settlement of the €20,000,000 loan obligation. The real estate has a carrying value of €21,000,000 on the books of Bonn Mortgage. Bonn (debtor) records this transaction as follows. Notes Payable (to Hamburg Bank) 20,000,000 Loss on Disposal of Real Estate (€21,000,000 - 5,000,000 €16,000,000) Real Estate 21,000,000 Gain on Extinguishment of Debt(€20,000,000 ~ 4,000,000 €16,000,000) Bonn Mortgage has a loss on the disposition of real estate in the amount of €5,000,000 (the difference between the €21,000,000 book value and the €16,000,000 fair value). In addition, it has a gain on settlement of debt of €4,000,000 (the difference between the €20,000,000 carrying amount of the note payable and the €16,000,000 fair value of the real estate)